Category Archives: Economics

What Caused The Great Recession (Detailed Economic Analysis)

Below is a term paper I wrote for an Economics course during my senior year at Washington University in St. Louis.  Economics 448W – Current Macroeconomic Issues.  This post is obviously a bit longer than an average blog post.  Content is a required placeholder to be used as an SEO tool to promote this blog on search engines and promote the primary intention of this particular blog: inform others that that there are multiple Aaron Ganek’s.

I.  Primary Causes of the Economic Crisis
A.  Lack of Transparency as a Result of Financial Intermediation
B.  Government Policies Promoting Increased Levels of Consumption
C.  Inefficient Incentives as a Result of Anticipated Government Actions
II.  Explanation for Financial Collapse
A.  Classical Model: Supply-side Theory
B.  Keynesian Model: Demand Dominant
III.  Methods For Recovery
A.  Classical Actions for Recovery
B.  Keynesian Actions for Recovery
IV.  Conclusion
I. Primary Causes of the Economic Crisis
A.  Lack of Transparency as a Result of Financial Intermediation
The United States was at, or at least very close to, potential output and full-employment prior to the financial collapse at the start of the current Great Recession.  The sub-prime mortgage crisis brings to light the major flaws in the existing financial incentive and policy structure put in place to achieve such financial standing.  The lack of sufficient transparency in the loanable funds market as a result of financial intermediation triggers irresponsible lending practices and produces inappropriate means for borrowing.  The ensuing shock of financial crisis cripples credit and lending which sends shockwaves throughout the entire economy.
In 2001, mortgages are readily available to many households with little regard to past credit history.  Financially unqualified families see an opportunity to capture the American dream and become homeowners as a result of the favorable policies and practices that exists.  The families misunderstand the risks involved and make undesirable decisions under a pretense of bounded rationality.  The rapid increase in home prices over the previous decade generates inaccurate assumptions that home prices will continue to rise.  If households are unable to pay back the loan, they anticipate the opportunity to refinance on good terms and capitalize on the assumed increase in housing prices.   The wide availability and perceived low risk for such mortgages creates significant demand and captures many unqualified individuals.
A free market system should penalize firms who choose to take on such poor risk and consequently weed out these unqualified loans.  Although it is clearly not in the best interest of a mortgage firm to take on undesirable loans, such risk is passed from the originating firm to other investment firms through a process of financial intermediation.  The originator aims to sell the mortgage and all expected future payments on the loan to a secondary investment firm in return for liquid assets.  The loans are packaged together – some good, some bad – which reduces transparency in terms of the risk involved.  Sophisticated investors fail to accurately account for the lack of transparency because of the ineffective investment ratings structure.  The market overpays for the collection of loans because they undervalue the true associated risks.
The process is repeated by Wall Street firms who repackage the loans again in highly complex schemes such as collateralized debt obligations which creates even more unknown risk to the buyer.  Although buyers almost certainly have little understanding of the complexity of such investments, they are reassured of the quality of such loans by investment ratings firms such as S&P, Moody’s and Best.  Although buyers trust the investment ratings firms as a third party perspective, incentives exist for the investment ratings firms to align with the demands of the Wall Street firms.  A Wall Street firm can choose to bring its business to an alternative ratings firm if the results are not compliant with its wishes.  The investment ratings firm therefore balances its reputation and the demands of the Wall Street firm rather than provide an accurate third party perspective.
The lack of transparency as a result of financial intermediation provides significant demand for loans among potential homeowners and finds sufficient buyers to purchase the future payments of these loans in the secondary market at an inflated price.
B.  Government Policies Promoting Increased Levels of Consumption
Households allocate funds between consumption and saving.  During the 40 years immediately prior to the Great Recession, households choose to shift more and more income away from savings into personal outlays on consumption.  The proportion of disposable income set aside for consumption climbs 11% by 2008 to a total of 99% (see chart 1).  Consumption as a proportion of GDP rises from 62% to over 70%.  The personal savings rate among Americans drops from 12% to almost zero.   Although this shift reflects a change in preferences among citizens, the choice to consume more is a reaction to policies Alan Greenspan and the Federal Reserve enact in the years prior to the financial collapse.
The Federal Reserve adjusts monetary policy as an attempt to maintain balance between economic growth, inflation, and unemployment.  Primarily, the Federal Reserve influences monetary and credit conditions through control of the interest rate.  Following the September 11, 2001 attacks and again after the 2002 accounting scandals, the FED cut interests rates to avoid financial distress and to extend consumer confidence.   After an interest rate cut, money becomes more accessible for consumer spending and business investment.
Alan Greenspan acknowledges the effects of adjusted interest rates on the housing market and rationalizes that mortgage markets are a powerful economic stabilizing force.  Keynesian economics advocates that changes in aggregate demand have real effects on the level of total output within an economy.  Lower interest rates make credit more easily accessible and thus spur the housing market.  The increased home values and relaxed lending policies as a result of the low interest rates allow households to extract more equity from their investment.  Families are now able to consume value previously fixed in savings.
The historically low interest rates just before the Great Recession raises the value and liquidity of homes and leads to a housing bubble.  At such low rates, many people are encouraged to purchase homes even when it is not financially responsible to do so.   To finance consumption activities, households extract more equity from their homes.  In 2004 when the Federal Funds rate is set as low as 1%, Greenspan suggests the public consider Adjustable Rate Mortgages where the interest rates adjust to the current market conditions.  Inflated expectations are proven inaccurate after mortgage interest rates rise shortly there after and people are no longer able to afford the interest payments on their debt.  Chart 4 illustrates the low initial mortgage rates homeowners pay as part of an adjustable-rate mortgage and then explains the “reset” after the teaser rate expires in late 2005.  The initial low interest rate attracts individuals to purchase homes, but the interest rate hikes make it impossible for them to payoff the debt and triggers the housing bubble collapse.   The reset from artificially low interest rates reduces the demand for houses and home values plummet.  Homeowners are able to extract less equity from their homes to fund consumption activities.  Keynesian economic theory explains a reduction in aggregate consumption demand has a negative affect on output.
C.  Inefficient Incentives as a Result of Anticipated Government Actions
Anticipated government actions can misguide private economic behavior.  Moral hazard, as a result of implicit policies, modifies how firms assess risk.  Financial firms are so big and interconnected that the failure of one firm may devastate many other companies and even the economy as a whole.  To prevent such collapse as a result of a single company failure, the government is expected to intervene.  Because executives work under the assumption of government bailouts, the extreme downside of all investment decisions are capped and net present value decisions are not properly evaluated.
The substantial quantity of high-risk investments by firms prior to the Great Recession is evidence that firms did indeed expect the government to intervene if the company were to fail.  Moral hazard imposed by implicit government policies encourages firms to over leverage their portfolios and take on excessive risk.  Firms invest in sub-prime housing under the implied guarantee of Freddie Mac, Fannie Mae, and other financial institutions.  Even companies that accurately discount moral hazard problems are forced to invest in risky environments in order to stay competitive among other banks that do not correctly evaluate the market and see significant short-term profits as a result.  As the investment portfolio for firms take on more and more risk, the threat of market collapse grows and the potential need for government intervention rises.
When the housing bubble bursts, firms heavily leveraged with sub-prime mortgages collapse.  As anticipated, the government decides to bailout many firms it deems ‘too big to fail.’  Companies like AIG, Freddie Mac, and Fannie Mae receive large capital injections in order to prevent collapse.  Ben Bernanke argues that the potential side effects of the high expense imposed on the government are outweighed by the potential devastation as a result of the crisis.  Companies that invested in poor asset choices are not completely punished by their actions.  The Government intervenes instead of allowing the free market to take its course.
The Government bailouts set an undesirable precedent and raise moral hazard problems.  The bailouts are evidence of Government strategy to intervene and prevent collapse.  Firms are likely to expect similar actions in the future and, thus, continue to leverage excessive risk.  It is important to note that the Government chooses not to bailout firms like Lehman Brothers.  The move to allow Lehman Brothers to go bankrupt is unanticipated and may signal a shift in future government policy such that the moral hazard problem does not arise again.
II. Explanation for Financial Collapse
A. Classical Model: Supply-Side Theory
In the classical model, the loanable funds market adjusts to ensure demand is sufficient to purchase the quantities of goods available to buy at full-employment.   This is known as Say’s Law.  A reduction of employment and output levels as witnessed during the Great Recession is therefore the result of a decrease in total potential output.  Firms sell less not because lack of customer demand, but rather because they are unable to produce the desired quantity of goods.
A firms operation is dependent on the acquisition of liquid capital to fund its day-to-day operations.  The labor demand by firms is capped at the amount of working capital the firm can raise to pay its employees.  The financial crisis makes it difficult for firms to acquire the needed working capital.  In the short-run, without sufficient funds available to finance full capacity operations, output falls.
The financial intermediation and lack of transparency concerns that cause the aforementioned working capital constraints produce a transaction cost that forms a wedge in the loanable funds market.  The market struggles to efficiently adjust the interest rate to ensure that investment can absorb the savings.  As a result, the amount of savings and investment fall.  The decline in short-run investment diminishes the creation of future long-run capital.  The reduced level of capital results in a lower level of output.  Although Say’s Law continues to hold and the economy produces at potential output, in the long-run potential output is lower than it would have been.
B.  Keynesian Model:  Demand Dominant
Both conventional Keynesian analysis and radical Keynesian analysis agree changes in aggregate demand have real effects on the level of output.   The Keynesian paradox of thrift builds upon the idea that an increase in saving by an individual does not increase the total savings in society, but it does cause income destruction by shifting resources away from consumption.  Firms react to this lower demand and reduce output.  Demand is therefore an active element of economic growth.
A historic drop in consumption acts as a catalyst to the current economic crisis.  The collapse of the housing market cripples the credit and lending system and reduces total spending.  Firms are not able to sell all of their goods at the same level of output and have incentive to produce less.  Such reduction in aggregate demand instigates a fall in output and requires less employment to produce the quantity demanded.  Households compound the crisis through increased savings in an attempt to be more financially cautious after the recent disaster.
The financial collapse motivates individuals to spend less and save more.  The crisis makes clear that high consumption rates are particularly risky and many households shift their preferences accordingly.   Uncertainty about the future compels people to reduce risk further.  The paradox of thrift connects the spending reduction to a decline in output.  An increase in relative saving necessitates an equal decrease in consumption spending.  Therefore, every dollar saved destroys the income of the potential seller the individual chooses not to buy from.  The seller then has less money to allocate between his own savings and consumption.  As a result, when households choose to save more as a response to the economic crisis, they reduce aggregate demand and do not augment the nations savings.  Fazzari contends “a greater desire to save lowers production, reduces the incentive to invest, lowers the capital stock, and reduces the incentive to engage in research and development” (14).
III.  Methods for Recovery
A.  Classical Actions for Recovery
The classical model is supply-side driven and does not require explicit demand policy for recovery.  The loanable funds market adjusts the interest rate to ensure a state of full-employment and potential output.  Recovery is a natural process.  Government policies to simulate demand are undesirable because they crowd out private investment.
Government actions of the classical perspective curtail only to the prevention of future crises.  The objective is to reduce the transaction costs of intermediation and to alleviate the constraints of acquiring working capital.  The natural adjustment process in the loanable funds market becomes less effective as a result of financial intermediation.  The created wedge reduces total saving and investment relative to expected levels with transparency.  In the long-run, output is diminished as a result of the reduced level of capital created with less investment.  In order to ensure output is not reduced as described, the government must enact regulation that minimizes the complexity behind certain investments and limits the transaction costs of financial intermediation.  Accurate dissemination of the risks involved reduces the financial intermediation wedge in the loanable funds market and allows the economy to reach optimum output.
The Government must not establish policies that encourage firms to partake in fiscally irresponsible actions.  Financial collapses caused by moral hazard bring about working capital constraints and reduce output.  To avoid such moral hazard problems, the government must set a precedent that it will not act as a safety net for struggling firms.  The Government will always feel obligated to intervene unless it can be sure the economy does not become to dependent on or interconnected with one firm.  Regulation is needed to ensure firms do not grow to be “too big to fail.”
B.  Keynesian Actions for Recovery
The Keynesian response for recovery from the economic crisis necessitates explicit policy to increase aggregate demand.  The economy is no longer at a state of full-employment and labor and productive capacity are under utilized.  The government should choose to enact changes in monetary policy, government spending, and tax cuts as a tool to stimulate recovery.
Conventional Keynesian theory advocates that the market will return to full-employment and potential output without government intervention, but the natural process is undesirable because the economy takes a significant amount of time to recover.  As unemployment grows, real wages fall below the marginal productivity of labor and the real price level falls.  The same nominal value is then able to purchase more and, thus, real purchasing power increases.  Current owners of assets become wealthier and may choose to spend more.  The rise in real money supply reduces the interest rate and stimulates spending on consumption and investment goods further.  This adjustment process restores aggregate demand, and the market returns to full-employment and potential output.  The economy settles at higher saving, higher investment, and a lower interest rate.
The duration of the natural process for recovery can be shortened through Government stimulus packages.  It is desirable to minimize the length of time the economy operates not at full-employment and potential output.  Throughout the natural recovery process, some resources remain idle.  A stimulus ensures all resources are employed.
In contrast to conventional Keynesian theories, radical Keynesian analysis proposes once demand is diminished through increased saving, wage and price adjustment alone cannot restore the economy to full-employment and potential output.  Keynes argues contractionary devices such as deflation will counter benefits of increased aggregate demand resulting from wage and price adjustments.  For example, the increase in purchasing power stimulated by the adjustment does spur an increase in aggregate demand, but it also increases the burden of debt on households and firms.  Wealth is transferred from debtors to creditors whose personal preferences are likely to further reduce aggregate demand.  Additionally, expectations for lower price levels in the future encourage individuals to delay spending, and the potential for falling interest rates may actually raise the real interest rate which will reduce spending.  Radical Keynesian economists believe the market will not naturally recover and argue Government stimulus is necessary.
In order to quickly recover from the economic crisis, the government must stimulate aggregate demand.    The government can use monetary policy to control the money supply and stimulate the economy by lowering the interest rate which should result in increased spending.  Monetary policy is immediate and efficient, but its impact is limited because the interest rate cannot be lowered below zero.  Chart 5 illustrates that current Federal Funds Rate has hit the zero-bound and monetary policy as a tool for stimulus has been exhausted.  It is likely that additional stimulus is required for quick recovery.
To further increase aggregate demand, the government must choose either to increase government spending or to provide a tax-cut.  Government spending creates an opportunity to employ idle resources, which result from the reduction in desired output in the market, and artificially return the market to full-employment and potential output.   Investment in infrastructure and other goods requires planning so recovery effects are not immediate.  The Government must be careful to ease spending when the economy approaches full-employment and potential output or else it may crowd out private investment.  Instead the government may choose to issue tax cuts to put money into the pockets of spenders.  Tax cuts are not 100% efficient as individuals who choose to save some or all of the provided cash do not help stimulate the economy.  The debate between the productivity of government spending and of tax-cuts is a political question.  In the event of economic crisis, most agree that the government must leverage a deficit in one way or another to stimulate the economy.
IV.  Conclusion
The economic crisis fundamental to the start of the Great Recession originates from the lack of transparency caused by financial intermediation, policies which encourage excessive spending, and established government precedents which promote moral hazard issues.  Output falls significantly during the aftermath of the economic collapse because of what I believe to be a lack of sufficient demand.  In order to recover from the severe economic recession, Keynesian economists argue the US needs to enact strong stimulus packages to spur aggregate demand.   While it is unclear whether the market can recover naturally after such shock at all, at a minimum, I expect sticky prices will significantly hamper any recovery without government intervention.   Looking forward, I push for regulation to ensure that companies do not become over leveraged and interconnected.  Accounting policies must be put in place to promote transparency.  Furthermore, I hope an economic system is established which provides incentive for both short-term and long-term objectives.  I believe, with these principles in place, the economy will mitigate the effects of the next recession.
Bibliography:
Cynamon, Barry Z., and Steven M. Fazzari. “Household Debt in the Consumer Age: Source of Growth—Risk of Collapse.” Capitalism and Society (2008): 1-27. Print.
Faber, David. “House of Cards.” CNBC ORIGINAL DOCUMENTARY. CNBC. New York, NY, 12 Feb. 2008. Television.
Fazzari, Steven. “A Penny Saved May Not Be a Penny Earned: Thinking Hard About
Saving and the Creation of Wealth.” Post Keynesian Workshop (2004): 1-27.
Charts 1 through 3 obtained from the class website.
Data for chart 4 collected from Freddie Mac. http://www.freddiemac.com/pmms/pmms_archives.html
Data for Chart 5 collected from the Federal Reserve.